ETF Liquidity: More than Meets the Eye

Terry Flanagan

Exchange-Traded Funds have evolved from a niche investment vehicle to a mainstay in retail, and increasingly institutional, portfolios. Over the past decade, total ETF assets under management soared nearly tenfold from about $230 billion to more than $2 trillion.

Compared with mutual funds, ETFs are seen as a lower-cost and more efficient way to gain exposure to stocks, bonds, commodities, and other asset classes, across a wide range of investment strategies and geographic regions.

Behemoths of the ETF space, such as SPDR S&P 500, iShares MSCI EAFE, and QQQ, generally have ample liquidity via electronic bids and asks, for even the largest institutional buyers and sellers. But there are an estimated 1,600 ETFs domiciled in the U.S., and outside the top tier, prices displayed on the screen aren’t sufficient for the end-user institutional investor or Registered Investment Advisor, for whom trading efficiency is critically important.

“Ninety percent of the conversations about ETFs start with, ‘look at all the cool stuff I can put in my portfolio.’ But then the next discussion for an institution is, ‘how liquid is it?’” said Michael Baradas, product manager for cross-asset strategies and ETF solutions at Bloomberg Tradebook.

Michael Baradas, Bloomberg Tradebook

Michael Baradas, Bloomberg Tradebook

Baradas noted that the displayed liquidity for some ETFs are similar to the trading behavior of small-cap equities. That is, just dropping an institutional-sized order onto the so-called lit market would result in a substantial market impact.

The unique product structure of ETFs provides an alternate avenue to tap liquidity, which entails creating ETFs from the underlying basket for buyers, or redeeming ETFs for sellers. “What a lot of people don’t realize is that you can go to market makers who can literally create the shares for you on the fly, in large blocks,” Baradas told Markets Media.

RiverFront Investment Group, a Richmond, Virginia-based RIA that manages more than $5 billion, knows it must do better than posted bid and ask prices when transacting ETFs for clients. “Liquidity in the ETF world is all about liquidity of the constituents,” said Pete Quinn, RiverFront’s president and chief operating officer. “We don’t look at the wrapper. We look at the constituents that make up the wrapper, because that tells us about liquidity in the ETF.”

“As an institutional investor moving size, we’re very rarely on the bid or the ask side of the market,” Quinn continued. “We’re typically dealing in the constituents of the ETF through the redemption and creation process, as opposed to going out to the marketplace and lifting a bid. If I’m a retail investor and trying to buy 1,000 shares of an ETF, then I need to look at the liquidity of the market itself.”

Bloomberg Tradebook acts as an agency ETF broker, which facilitates trades on behalf of clients but does not itself act as a market-maker. The firm’s Request for Quote (RFQ) electronic platform is a current-day version of the old model in which a buy-side investor had to make a round of calls to broker-dealers to shop for the best price.

“We figured, why don’t we create an electronic solution for this?” Baradas said. “We are still the broker in the middle, but we’re connecting the buy side directly to multiple buy-side market makers,” who have emerged as liquidity providers over the past half-decade in the wake of the Dodd-Frank regulation constraining sell-side banks.

Agency brokers play a key role in the ETF market, effectively serving as a storefront or showroom for pension plans and other institutional asset owners, said Dan Draper, managing director at Invesco PowerShares Global ETFs.

“The agency broker is really important,” Draper said. “They make sure that asset allocators can come in and get good efficiency, good pricing and not overpay commissions, even if they are taking a longer time horizon.”

Featured image by Ptnphot of/Dollar Photo Club

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